Buffet’s Secrets Unveiled

Posted on Feb 7, 2014

Is Warren Buffett’s success the result of luck or skill? That’s the question that a team made up of two analysts from one of the world’s largest and most sophisticated hedge funds, and a professor at New York University sat down recently to answer once and for all.The team’s conclusion?Not only is the extraordinary performance over the years the result of Buffett’s skill, but it can also be replicated by the ordinary investor.To be clear, this is an old question, dating back to at least 1984, when Buffett squared off against economist Michael Jensen at the infamous 1984 Columbia Business School conference commemorating the 50th anniversary of Benjamin Graham and David Dodd’s landmark bookSecurities Analysis.

Jensen, a follower of the efficient-markets school, which believes that profits cannot be systematically earned from analyzing public information about stocks, argued that Buffett’s success was simple luck. He went on to compare the tossing of coins to stock selection and that based on consistently lucky coins tosses good returns are achieved. So basically, Jensen’s position was that Buffett was a lucky tosser! Buffett, who has a great sense of humour, rebuffed this argument labelling him as a lucky tosser.

So the question has lingered in the minds of investors and analysts because of a lack of rock-solid statistical proof either way. Until now, that is.Uncovering Buffett’s SecretIn a recent paper, appropriately titled Buffett’s Alpha, the team from the hedge fund and New York University claim to have solved the puzzle:They show that Buffett’s performance can be largely explained by exposures to value, low-risk, and quality factors. This finding is consistent with the idea that investors from Graham-and-Dodd school follow similar strategies to achieve similar results and inconsistent with stocks being chosen based on coin flips.Therefore, Buffett’s success appears not to be luck.The team also found that Buffett’s strategy is straightforward and implementable by the average investor. These are both of traits that Buffett has always claimed.

There has also been the argument, for instance, that Buffett’s success stems more from his ability to purchase private companies in total versus his selection of individual publicly traded stocks.

This simply isn’t true, say the study’s authors. “We find that both public and private companies contribute to Buffett’s performance, but the portfolio of public stocks performs the best, suggesting that Buffett’s skill is mostly in stock selection.”

How does Buffett pick stocks? Several general features of his portfolio were identified. He buys stocks that are safe, cheap, and high-quality. No big surprise there.

So How Does this stand up under examination?

To test this, I went back and looked at the reasoning behind Buffett’s now-largest public holding: Wells Fargo (NYSE: WFC). In his biography of Buffett, Roger Lowenstein states “Generally, Buffett did not like banks, but he had been pining for this bank for years. Wells Fargo had a strong franchise in California and one of the highest profit margins of any big bank in the country.”

But it wasn’t until 1990, the single worst year for banking since the crisis of the 1930s, that Wells Fargo became cheap enough for Berkshire Hathaway to consider owning more than the somewhat marginal position it had staked the previous year.

As Buffett explained in his letter to shareholders at the time:

Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled — often on the heels of managerial assurances that all was well — investors understandably concluded that no bank’s numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.

The point being, all three of the identified variables were present. While the industry was in chaos, Wells Fargo was safe. Buffett estimated that the worst-case scenario for the bank was a break-even performance the following year. It was cheap, as its stock had fallen by 50% since the beginning of 1990. And it was high-quality.

So, what can you, as an individual investor take away from this?

So what is the message that you should take away from this study? Having personally spent some 30 years in the world of finance and investing the more that I learn about investing, the more it becomes apparent that people who fail at it are either impatience and or have an irrational willingness to take short-term bets on speculative stocks.

As this study demonstrates, however, this is the polar opposite of what’s made Warren Buffett so rich and successful. He buys bona fide businesses for the long run and he waits to do so until they’re trading for a sufficiently large discount to historical value. It doesn’t take a genius to do this. You can do it as well. What it takes is patience, discipline, and a long-term time horizon.